The presence of digital ID infrastructure can influence the design and roll-out of CBDC initiaties, writes Claus Christensen.
Prominent economists, international bodies, local central banks, leading financial institutions and crypto investors are all contributing to a highly fascinating debate regarding the future of money. At the centre of it, there is a sky-rocketing interest in central bank digital currencies (CBDCs). In essence, a CBDC is a new type of fiat money that provides the public with direct digital access to central bank reserves instead of restricting such access to commercial banks.
The potential benefits of CBDCs are far-reaching. First, according to the International Monetary Fund, these currencies could be more cost efficient than physical cash due to their lower transaction cost. Second, they could promote financial inclusion by providing easier access to money via mobile devices to unbanked populations in remote areas. Finally, they could give central banks an additional and powerful tool to activate new monetary policies.
The backbone of payments
Pushed in equal measure by the fear of missing out on these benefits and the need to counter the extra-systemic power of cryptocurrencies, a growing number of countries have recently entered the CBDC race. The Atlantic Council’s CBDC Tracker is an incredibly useful resource for anyone interested in keeping up with the latest announcements.
As of August 2021, 81 countries – representing over 90 percent of global GDP – were exploring a CBDC. This amounts to a 230 percent increase compared to May 2020, when only 35 countries were considering a CBDC. To date, five countries have now fully launched a digital currency, with the Bahamian Sand Dollar as the first CBDC to become widely available. In addition, 14 other countries, including Sweden and South Korea, are now in the pilot stage and getting ready for a possible full launch.
Other notable examples include China, where the People’s Bank of China (PBOC) started experimenting with a digital yuan since early 2019. In fact, according to recent reports, $5.3 billion in digital yuan has already been spent during the trials. In April 2021, the Bank of Japan (BOJ) also launched the first phase of its own CBDC initiative, with a second phase planned for 2022. There are also wide expectations that the launch of a digital euro and digital dollar are increasingly becoming a matter of when rather than if.
The trend is so widespread that the Bank for International Settlements (BIS) dedicated a key chapter to CBDCs in its 2021 Annual Economic Report. The chapter explores in detail why CBDCs present a unique opportunity to design a technologically advanced representation of central bank money that could offer the key features of finality, liquidity and integrity. It even suggests that CBDCs could form the backbone of a highly efficient new digital payment system by enabling broad access and providing strong data governance and privacy standards based on digital IDs.
However, it is precisely around privacy and identity verification requirements that some issues arise, and these complexities vary greatly based on what design central banks decide to embrace for their specific CBDC projects. In fact, choosing a retail or a wholesale CBDC model might have far-reaching implications for the future of identity verification and KYC procedures.
A question of model
The following question summarises the retail vs wholesale dichotomy: should retail customers have CBDC accounts at the central bank, thereby bypassing retail banks altogether (retail model)? Or should private intermediaries, like in the present form, administer CBDC accounts (wholesale model)?
According to a recent PwC report, so far, retail efforts have produced two live projects in the Bahamas and Cambodia, while no wholesale CBDC projects have reached this maturity level yet (around 70% of declared wholesale projects are running pilot projects).
In the retail model, individuals and businesses would hold CBDCs through private accounts at a central bank. Intermediaries such as commercial banks would no longer be necessary because the central bank would take over the role of onboarding and handling all payment services. In this scenario, central banks would likely be required to perform KYC checks and AML monitoring of their account holders directly.
Central banks are not currently equipped to deal with the large numbers of retail customers in a traditional onboarding process based on collecting, processing, and verifying physical ID documents. But by fully integrating existing digital ID schemes or introducing new digital-first initiatives, they could reduce the workload to a manageable proportion.
In the wholesale model, the central bank would not onboard and service CBDC users directly, relying instead on existing intermediaries that have access to central bank accounts and can draw on reserve balances held there to provide CBDC money to users.
This set-up would likely see central banks delegate the majority of operational tasks and consumer-facing activities, including onboarding, to commercial banks and other payments service providers (PSPs). According to the aforementioned BIS report, this approach would guarantee the stability of value, ensure the elasticity of the aggregate supply of money and oversee the system’s overall security.
At first glance, it might seem that going down the wholesale route – as many advanced economies with more developed interbank systems and capital markets are doing – could mean that no significant changes are to be expected in terms of KYC and AML procedures, i.e. commercial banks and payments providers would continue to perform these procedures using the systesm they already have in place.
However, while that might be the case in the short term, it will not hold true for long. The same way that the rise of electric cars is fostering the introduction of a new network of infrastructures to help those cars function properly, the rise of CBDCs might foster new digital ID infrastructures that can reflect the speed, ease-of-use, and digitally native nature of the new currencies themselves.
The role of digital ID
Regardless of the specific design model involved, the rise of CBDCs is very much located at the crossroads between the ongoing digitisation of governmental services and the advent of digital finance.
In this sense, Sweden represents a very interesting example. Private banks first introduced the Swedish federated digital ID scheme in 2003, but the eIDs thus created are now also accepted as a form of identification by government authorities.
In April 2019, the Riksbank – Sweden’s central bank – announced it was studying the introduction of an e-krona, whose primary goal would be to increase the safety and efficiency of electronic transactions. A review into the feasibility of having Sweden move to a digital currency is expected to be completed by the end of November 2022. Still, Sweden has to date already provided high levels of technical insight into its digital currency project.
Another example is Singapore, where an exploratory project into CBDC concluded in July 2020, when the Monetary Authority of Singapore (MAS) completed numerous tests of blockchain-based payments solutions in multiple currencies and developed special interfaces to connect with other blockchain networks. Such a level of technical sophistication is not out of character for a country that has been at the forefront of digital finance trends for a long time.
From a digital ID point of view, for instance, the government introduced a digital personal data platform known as MyInfo in May 2016 to streamline identity verification during online transactions. Since its introduction, the MAS does not require financial institutions that have been given access to a customer’s MyInfo data to obtain additional documents to verify the customer’s identity, and we expect the same rule to also apply if a local digital currency were to be introduced.
The examples of Sweden and Singapore teach us that the overall level of digitisation of a society’s financial services is a key factor to consider in relation to CBDCs. More specifically, governments should consider the practical aspects of the identity verification process involved in the issuance of their digital currency, as these are likely to have an impact on which design model is best to adopt for their CBDC.
For instance, having a functioning digital ID scheme for the provision of financial services already in place could be an incentive to adopt a wholesale CBDC model that leverages an existing and extensive network of commercial banks and PSPs. On the other hand, introducing a retail CBDC paired with a new digital ID scheme to promote financial inclusion on a large scale may represent a unique opportunity to leap-frog digitisation efforts for jurisdictions that have historically been lagging behind.
In conclusion, whatever the model involved, digital ID schemes have a role to play in the successful roll-out of CBDCs. Keeping this in mind can help us predict which countries are more likely to cross the CBDC finish line ahead of the rest in this very exciting and potentially era-defining race.
Claus Christensen is CEO & Co-Founder of Know Your Customer Limited.